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High rate vs snowball method

If you have multiple forms of debt, how should you prioritize repayment? This video analyzes two popular strategies for debt repayment to determine which will cost less money over time.

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Video transcript

Let's say that these four items here represent your outstanding debt. So, the first number in each row is the outstanding loan balance. For example, this credit card, you have $500 outstanding balance. The second number is your APR, 15% for the credit card, 30% for the retail card, 10% for this loan, 5% for this loan. And then the last number I have listed here is your minimum payment. So, you have a minimum payment every month. Let's see, 20 plus 30 is 50, plus another 150. You have a minimum payment every month of $200. And your total outstanding loan, your total outstanding loan balance is, let's see. This is 3,500 plus 500 is 4,000 plus 4,000 is 8,000, plus another 2,000 is 10,000. So, you owe $10,000. Your minimum payment is $200. But let's say that you have more than $200 to pay every month. Let's say that you have $300, $300 every month available. So, the question is, what do you do after you pay the minimum payments? What do you do with that extra hundred dollars? As you can imagine, I'm going to tell you that you should use that to pay down your debt so that you can pay it down as fast as possible. But then you might say, "Well, which debt do I pay down first? "Do I just split that $400 four ways "to pay off 25 more than each of these minimum payments? "Do I pay the largest amount first, "the smallest amount first? "Do I pay the highest interest first?" And those are all possible ways of doing it but the mathematically optimal way of doing it is to pay down the highest cost debt first. So, that method is often called the high rate method. Where you want to pay down your highest, your most costly debt first. Which in this case is the retail card. So, the order in which you would pay it is, the order in which you would pay it is-- You would pay all the minimum payments and then any extra money that you would have, you would put it towards the retail card first. Once the retail card is paid off, let's see, after that the credit card has the next highest interest. So, copy and paste. Then, these two loans, they're already in order, 10%, 5%. So, I'm just ordering these form highest interest cost to lowest interest cost. In this world, you would want to, essentially, rank them in this way. You obviously have to pay their minimum payments every month which is $200 but then I would take that extra hundred dollars that you have available and put it to the most costly debt. So, I would put that extra hundred dollars right over here and try to pay this one down as fast as possible. Once that is paid off, then I would put any extra you have after the minimum payments to the credit card. And once that's paid off as well, then to loan A. Once that's paid off, to loan B and hopefully you are then, you might be then debt-free. If you did the high rate method right over here, you would, and you don't incur any new debt, you would be debt-free after 47 months. And you would pay an aggregate interest of approximately 39, $3,904 in interest over those 47 months. So, you say, "Okay, Sal, I get it. "This is the mathematically optimal thing to do "to get rid of your most costly thing first "which makes sense`and then your next costly thing "and then on and on." But you tell me, "Well, you know, psychology matters here. "Psychology, maybe, got me into this debt a little bit. "So, for me, I don't like having my brain always thinking "about all of these four pieces of debt. "So, I would just love to maybe not have to worry "about four things and get to worrying "about three things as soon as possible "and then two things as soon as possible." So, if you think that is helpful, there is a method where you say, "Okay, I'm gonna pay my smallest balance first "to just get that out of the way." Now, keep in mind, if that works for you, if that psychologically allows you to say, "Okay, that hundred dollars "is gonna make a bigger dent here," that's great. That's actually called the snowball method. Let me write here. The idea is a snowball, you get one debt out of the way and then you snowball into the next. But that, just to be clear is not mathematically optimal. It will take you longer to pay your debt and you will pay more interest. But, I'll just write that down because the important thing is that you feel that you should put the hundred dollars to paying down the debt that you don't use it for something else. So, the snowball method would order these things differently. Under the snowball method, you would put your-- Let's see, your credit card has the smallest loan balance. So, let me put that first. So, copy and paste. That's your credit card. Then, after that, let's see, you have loan A. You have loan A here. So, let me copy and paste that. Copy and paste loan A. Then you have loan B. So, loan B. Oh, actually, yup, then you have loan B. Copy and paste. And then you have your retail card. And then you have your retail card. And you could see why this isn't gonna work out well. Why this isn't gonna work out well mathematically 'cause you're leaving your most expensive-- You're paying just the minimum on your most expensive, on your most expensive debt. Not only is it expensive, it's expensive on a large amount. But, let's just go through the... So, you might find it more psychologically easy to do this method because you at least get rid of the credit card debt a lot faster. You'll get down to only three sources of debt versus four much, much faster. So, in this situation, you would pay down the credit card first. So, you'd be able to knock these off faster. But, just so you make sure, there is a trade off. In this one, it's gonna take you 54 months to pay of your debt. So, seven months longer, more than half a year longer. You're going to be making payments. And you're going to pay almost double in interest. You're gonna pay 6,000, approximately $6,000 in interest in this situation versus I guess about 50% more. So, here you're paying almost 4,000 in interest. Here you're paying roughly $6,000 in interest over the 54 months. The mathematically rational one to do would be the high rate method. But this is, you know, whatever it does. Assuming you have the money, as long as you put it down towards your debt, at least you're making progress. And this is a method that some people might want to use more for psychological purposes. I have to admit, I have done this where I just wanted some debt out of the way so I pay down the small one first. But, if you really want to optimize for interest payments and paying down fast, you want to take out your costliest things first.